Examination of Witnesses (Questions 160-179)
SIR CALLUM
MCCARTHY
AND MR
JOHN TINER
24 OCTOBER 2006
Q160 Ms Keeble: Do you think the
balance is right at the moment, or not?
Sir Callum McCarthy: No, I think
the balance is clearly wrong because there is a huge information
asymmetry between the strengthened power of the producers and
the ability of many consumers, and that is something that we are
trying to tackle in all sorts of ways.
Q161 Chairman: Sir Callum, on the
issue of Northern Ireland, I was over there in the summer talking
to many people on the issue of financial inclusion, which the
Committee is interested in. The Consumer Council and others brought
to my attention the fact that there is no office of the FSA in
Northern Ireland and, furthermore, there is a lack of targeted
resources and activities relating to specific financial issues
for consumers in Northern Ireland. It is that area that they were
focusing on. I think there is something the FSA could do to raise
its profile there.
Sir Callum McCarthy: Could I take
that away, Chairman? We will look into it.[3]
Q162 Mr Breed: Can we just turn briefly
to an area of activity which causes me and, I think, some others
concern, and that is hedge funds. Can I just draw your attention
to Mr Tiner's report in the annual report, which says: "We
have been careful to be proportionate in our regulation of hedge
fund managers bearing in mind the highly mobile nature of their
business and their ability to trade into the UK from overseas."
Then turning to your memorandum that you sent to us, it says,
amongst other things: "FSA authorised firms account for over
three-quarters of the hedge fund assets managed by European based
firms." The first question is: do you think that you have
got the balance right if the regulation is such that it attracts
three-quarters of the hedge funds, and are you happy that the
existing regulatory regime is sufficient? Second: in the last
part of your report in this respect you say: "We have set
up a specialist hedge fund unit to carry forward our regulation
of these firms". Can you perhaps give us some indication
as to what that unit is doing and how you believe that regulation
may be, perhaps, improved without disproportionately affecting
the competitive nature of the UK?
Sir Callum McCarthy: Can I just
say that we approach hedge funds on the same risk-based approach
that we approach all our activities. There are a very large number
of hedge fund managers in London, most of whom come and go because,
like all hedge fund managers, their half-life is relatively short.
The challenge for us is, first of all, we authorise all hedge
fund managers to make sure that we have got a proper authorisation
process, and then the question is: how do we actually exert our
influence most productively. We have chosen to do it in two ways:
one is we have a six-monthly survey of the prime broker dealers,
which are the institutions which extend most of the credit and
other facilities to the hedge fund managers, and that gives us
a means of looking at the total exposure of hedge funds, which
is important in terms of the prudential issues which are raised—i.e.
the threat to financial stability. That we have done. We publish
the results of that and discuss the results of that with the prime
broker dealers, and we can talk about that. The other thing that
we have done is to identify some 35 hedge fund managers who are
responsible for sufficiently large chunks of activity for us to
really supervise them in a way that is comparable to the way that
we supervise other high impact firms. For those we discuss with
them carefully their systems and controls and a whole range of
other issues. Those are the essential features that we have done,
and I think it fair to say that other regulators around the world
are watching what we are doing with great interest because the
regulation of hedge fund managers raises an interesting and quite
difficult set of issues.
Mr Tiner: I think the success
of London, if that is the right way to describe it, has not been
because there is a weak regulatory system here. I think if you
look at other international capital markets, the international
credit markets, the international bond markets—certainly
the international corn exchange markets—the sort of percentages
that you quoted for hedge funds would apply there as well in the
European context, with London being either number one or number
two to New York in many of these markets. I think it just follows
a pattern. Our worry would be that if we had a disproportionate
effect on these companies that they would take their business
offshore but they would still trade the markets in London, and
so we would, in a way, lose touch and then lose the ability to
actually intervene. I think that the regime we now have, which
Callum has described, and the specialist team we have recruited
are now looking quite critically at things like how the hedge
funds are managing their conflicts of interest, because it is
quite often that the hedge funds are taken in over the wall, so
to speak, and when an investment bank is trying to put together
a transaction or a convertible bond is being converted into equity,
or whatever, the market is being tested. We are very keen to see
at close hand how the hedge funds are handling that kind of risk
so that they do not trade on that sort of inside information,
for example. That specialist team is quite active particularly
following the major 35 hedge funds which comprise a large part
of the market. I think there is one thing which is slightly curious:
whenever I go and meet the hedge fund managers as a group they
all seem to be terribly keen to be regulated by us. I say to them:
"I think you are a bit too keen", because I think there
is some sense that we are a badge of respectability and we just
have to be wary of that as well, I think.
Q163 Mr Breed: Is the unit going
to be publishing any findings? Has it unearthed any concerns?
Mr Tiner: The unit will produce
public reports when they do what we call thematic work; so when
they look at particular themes. For example, they look at how
hedge funds value their illiquid and complex positions; they look
at conflicts of interest, and at the moment they are looking at
side letters with major investors that we, in fact, talked about
earlier this year. Yes, the results of that will be made public
in a general sense.
Q164 Kerry McCarthy: With the move
towards more of a principles-based regulation away from rules,
what efforts have you made to ensure that the consumer does not
lose out? You will be aware, I am sure, of criticism from Which?
that you have not conducted any sort of cost-benefit analysis
of the impact on the consumer. Do you think that is something
that you should have done or should be doing?
Mr Tiner: I suspect it is not
possible to do, is the truth of it, because you would have to
make so many assumptions about actually how many more principles
would be working in practice to determine whether the consumer
is better off or not. It is our very strong belief that the highly
prescriptive nature of the current regulations has meant that
the companies have focused much more on the ticking of boxes than
thinking about what do they actually need to do to treat their
customers fairly. We are trying to turn the whole focus of the
financial services industry to building Treating Customers Fairly,
in all its component parts, into their business processes, and
the way in which they motivate people, the way in which they reward
people and, indeed, to try and see (and many companies are coming
forward with very good ideas about this) how they can create shareholder
value out of treating their customers fairly. So the regulation
does not become something which they have to do in a very rigid
way, which the research might suggest the consumer does not understand
well enough, to one where the consumer is much more at the heart
of their business. So that is somewhat an act of faith, I would
accept.
Q165 Kerry McCarthy: Is not the problem
that the vast majority of firms will be quite willing to go down
the route but then you lose the power to more strictly control,
maybe, the 5% or so that are not willing?
Sir Callum McCarthy: I think there
is a danger in believing that our movement towards more principles-based
regulation is, as it were, driven by a desire to impose lower
costs on the producers and the firms. That is not the principal
driving force. It may be—and I think will be—a good
side benefit, but this is driven by a belief that this is a better
way of actually achieving our statutory objectives, including
that central statutory objective of appropriate consumer protection.
I do not believe there is a tension between appropriate consumer
protection and a more principles-based regulation.
Q166 Kerry McCarthy: As you move
towards a principles-based approach there will be a need for guidance,
presumably. How do you strike that balance so that the guidance
does not, in effect, become another set of rules?
Mr Tiner: A very good question
indeed. If you think about the paper that we have just published
that Callum referred to a moment ago on distributor and product
provider responsibilities, they are setting out our thinking about
that aspect of treating customers fairly. We do not intend to
turn that into formal guidance, which then has the degree of formality
you are describing and becomes a sort of second set of rules.
However, it is important the industry should know what is in our
minds, and the industry can then work out how to interpret it.
There is also a fear then, beyond that, about how can we take
enforcement action where we do not have a precise rule to point
to but we have a breach of a principle? We are quite satisfied
that that will not curtail our enforcement activity. In fact,
many of our enforcement cases, which is not a well known fact,
have been based on principles already. I think the legal ground
is well developed there.
Sir Callum McCarthy: Of the fines,
which were among the largest fines that the FSA has ever imposed,
at least two of them have been for breaches of principles: the
Citigroup MTS trade fine was for a breach of a principle, and
the recent Deutsche case was for a breach of principle. So I do
not think that the movement towards more principles-based regulation
is going to inhibit us or prevent us from actually taking enforcement
action against, as you said, the 5%.
Q167 Kerry McCarthy: You think that
firms can cope—particularly the smaller firms. Is there
not a danger that they are going to adhere to the guidance just
because they do not want that degree of uncertainty? You talk
about them taking the guidance as guidance and making their own
decisions as to how they operate, but there must be some firms
that will think: "We do not want to run the risk of being
deemed to be outside the principles".
Mr Tiner: I have heard it said
that this is fine for large firms with very large legal departments,
compliance departments and risk management departments, and very
difficult for the sole trader. Actually, I am not sure about that.
I think it may almost be the opposite. I think in the large companies
these legal departments and compliance departments are saying
to their senior management: "We like this very prescriptive
approach because we can (a) do the job and (b) we know where we
are on everything", which, frankly, I think reduces the sense
of management responsibility at the top for doing the right thing.
I think the small trader can look at it and say: "I can look
at myself in the mirror and say: am I treating my customers fairly
in this respect?" There is plenty of help around on that,
on our website and other places, to help them to come to terms
with it. I do not think they will need large departments and access
to lots of consultants to do that.
Q168 Kerry McCarthy: Final question:
in terms of the staff that you employ, has this caused an issue
in that you are used to regulators that are there to apply rules
and they are now to interpret principles and issue guidance? Have
you had to make new appointments or re-jig things around?
Sir Callum McCarthy: The move
that we are determined to make raises really big issues both for
firms and for us as a regulatory organisation. We have, for example,
recently had a major training exercise to train large numbers
of people in terms of the new way that we do a central risk assessment
called ARROW. We have a whole series of other changes that will
be required as we roll this out over the years to come. It is
a big cultural and managerial change in the FSA.
Q169 Mr Gauke: I would like to turn
to the issue of MiFID. Last year Kerry asked you, Sir Callum,
about whether the costs would outweigh the benefits. Your response
was to the effect that it was really too early to say at that
point. We are a year further on, and I know the process is not
complete, but where do you think we stand at the moment?
Sir Callum McCarthy: I think the
first thing I would say, Chairman, is that it is still a bit too
early to tell—it is a bit like Mao Tse Tung and the French
Revolution.
Mr Cousins: I think it was Zhou
En Lai.
Sir Callum McCarthy: I am sure
it would have been Mao Tse Tung as well! It just shows you should
never go beyond your remit! If I can return more seriously to
the question, we are required to do a cost-benefit analysis of
all the rule changes that arise out of MiFID, and have done so.
In addition, even though we are not required to do so, we have
made an estimate of the total cost in the UK of implementing MiFID.
We think that it will be between three-quarters and one billion
sterling, and that is based on what we now know. We think that
the implementation cost will be in that range. We will publish
our work on that next month. The benefits are much more difficult
to estimate but we think that they are likely to include continuing
benefits of around £200 million a year and then there are
wider benefits which could be very significant and which are,
at the moment, almost totally unknown. If the cost of capital,
either equity or debt, in Europe were to come down by one or two
basis points that would have a quite fundamental effect, and we
will just have to wait to see whether that actually happens—if,
after the event, it is possible to untangle it. I would just make
one other point: as I said at the annual public meeting of the
FSA last year, one of the things which I regard as deeply regrettable
is that there has been this huge initiative, important and costly
initiative, which was done without proper cost-benefit analysis
within the Commission. We very strongly support Commissioner McCreevy
in his determination to use impact assessment and cost benefit
analysis, because it is not a good thing that at this very late
stage we should not be able to answer the question you have raised.
Q170 Mr Gauke: Would it be fair to
say that it is easier to quantify the costs at this stage than
it is to quantify the benefits?
Sir Callum McCarthy: Yes.
Q171 Mr Gauke: Looking at the costs,
can I ask to what extent you think the costs are going to be incurred
because of the terms of the original Directive, if you like, and
to what extent the costs are going to result as a consequence
of implementation by the FSA? Perhaps, in answering that question,
you could answer the concern that as a whole the FSA have, perhaps,
been overly literal, or overly cautious in its implementation.
I know best execution is one that is often mentioned, but how
do you respond to those concerns?
Sir Callum McCarthy: Can I take
the issue of gold-plating generally? Our general policy has been
copy out, which is the most basic transmission that is possible.
There are a very limited number of instances where we have thought
it right to go beyond the Directive. Each of those will be justified
by both an analysis of market failure and a cost-benefit analysis.
For example, there are some reporting issues where we think there
is a good case in terms of our ability to oppose market abuse.
There are also one or two instances where we have existing requirements
which we are, pro tem at least, going to maintain because
we think they are useful (there are issues associated with the
menu and IDD which fall into that category). Generally, we are
taking a very cautious copy out approach.
Mr Tiner: May I add two points
in addition to the points Callum has made about where we would
go beyond. One is what we have done on soft commissions and the
unbundling of research, which has been very widely welcomed—and
strangely, in my mind, does not fit into MiFID. We have to make
the case to keep that, but it is something that has worked very
well for London in the two years since that market has been unbundled.
The other area where I think there is quite a bit of misunderstanding
and misconception, is that we have gone beyond on best execution,
where we are publishing a paper about our proposals on best execution
either later on this week or on Monday. It is clear to me that
we are not and that the great advantages to London over many years
of the dealer market, the principal-to-principal market, the very
deep liquidity pools that exist in some markets, we can keep within
the terms of the directive. The directive does raise significantly
the expectations by institutional investors, fund managers, that
if they ask for best execution they shall be given it. That is
not a function of regulation; it is a function of the raising
of the issue through the MiFID. But I am quite satisfied, as I
said in my speech at the British Bankers' Association two weeks
ago, that we do now have a solution to best execution, which has
not been easy to arrive at—because it is written in very
complex ways and all over the place within MiFID and to make sense
of it in a real market sense has not been easy—but I think
we have ended up in a good place.
Q172 Mr Gauke: You feel that the
industry will be satisfied with the full details?
Mr Tiner: All the soundings I
have taken suggest that will be the case, yes.
Q173 Mr Gauke: The logic of what
you are saying—and best execution provides a good illustration—is
that there are a lot of problems in the original MiFID text, if
you like. Do you think it was wise for the Treasury to agree to
the MiFID text as it currently stands? Did the Treasury have the
grasp of the detailed issues and the industry contacts that the
FSA clearly has when it was negotiating at a level 1 stage?
Sir Callum McCarthy: I think the
answer, basically, to that is yes. They had that knowledge, partly
because we helped them, in addition to their own contacts. Truthfully,
the questions there must be on any negotiation of a directive
are a whole series of tactical questions, on which I cannot comment
at all because that depends on people who are immersed in the
negotiation. In terms of, did they have access to an understanding
of what the implications were: yes, and we helped give them that
understanding and they then took the decisions.
Q174 Mr Gauke: From the FSA's point
of view, given the very substantial costs that are going to be
there—some uncertain benefits but substantial costs—do
you feel there were too many compromises made? Was it a compromise
that was in the UK's best interest?
Sir Callum McCarthy: I do not
think that I am competent to make that judgment because it depends
on a whole variety of other issues which are, in that great phrase,
"above my pay level".
Mr Gauke: Mr Tiner, do you have anything
to add?
Q175 Chairman: If it is above Sir
Callum's, it is above yours, is it not?
Mr Tiner: Thank you, Chairman,
for getting me out of that one!
Q176 Chairman: David mentioned market
abuse and one area of market abuse that has been brought to our
attention is insider trading. I know that your own statistics
show a marked tendency for abnormal price movements to occur ahead
of key corporate announcements. This is an area, as a Committee,
we are thinking of looking at, but the ABI have written to us
as well saying that they believe there are far too many anticipatory
share-price movements ahead of price-sensitive announcements.
What are you doing about that?
Sir Callum McCarthy: First of
all, we are trying to raise the awareness of this. That is why
we published the research to which you have referred, Chairman.
We are also investing very heavily in a new IT system which will
enable us to look at the market and across the market and identify
aberrations better. We are also, as John mentioned in relation
to, for example, hedge fund managers, making sure that we pursue
the importance of segregation of information and pursue those
instances when there appears to be breaches of it. I would say
that we have had at least one successful prosecution, which was
the GLG and Mr Jabre enforcement action, where we took action
against both a firm and an individual for the way in which they
used information improperly.
Q177 Mr Love: Following up on that,
could we say that Gordon Gekko has moved from the United States
to the UK because of easier dealings in the London market?
Sir Callum McCarthy: I would basically
say that there is no evidence for that at all! I am sorry, that
was a slightly flip answer. I do believe that the question of
market abuse and insider dealing is a real question. It is a question
which in the UK and elsewhere it has been extraordinarily difficult
to deal with and we are determined to deal with it in as focused
a way as we can.
Q178 Mr Love: Do you think you are
dealing with it as effectively as the United States?
Sir Callum McCarthy: If you look
at the evidence in terms of what has been described as anticipatory
market movements, I do not think there is any evidence that the
US is a cleaner or fairer market than the UK.
Q179 Mr Love: In the year 2005 the
FSA produced a report on offshore operations. In the light of
the Dispatches report that appeared on television a couple
of weeks ago—and I hope both of you are aware of that—about
data protection in Indian call centres, do you have any plans
to revisit this particular report?
Mr Tiner: I did not see the programme
but I am aware of the programme and read about it. We said in
that paper—and it is a core piece of our regulation as business
models change and more outsourcing is embraced by the industry—that
the responsibility for the outsourcing operation is the senior
management of the company that we regulate. We have absolutely
no intention of changing that. I think we have to look to the
boardrooms of the big UK institutions who are outsourcing, whether
it is to India or to other places, to satisfy themselves that
data is protected, that fraud is reduced, that there are back-up
systems if the systems collapse. They need to be aware of criminal
gangs who try to infiltrate some of these organisations and so
on.
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